For several months, the outlook for the euro area has improved thanks to the positive results that have been achieved over the national and European level. Budget deficits have decreased considerably since 2011, particularly in the countries hardest hit by the crisis. Trade deficits of these countries have disappeared through fiscal consolidation and structural reforms implemented to enhance the competitiveness of enterprises. At European level, the decisions taken to create a banking union represent an important step towards the consolidation of the monetary union. The establishment of the European Stability Mechanism (ESM) with a lending capacity of € 500 billion has equipped the euro area with an essential tool that was tragically missing when Greece’s imbalances came in the spotlight. While regretting that the crisis has failed to give the euro area a central budget to help countries to more easily cope with asymmetric shocks, we can consider that the ESM is playing a similar role by organizing financial transfers to countries in crisis, but such transfers must be repaid (they take the form of loans) and accepted (since they are subject to strict conditionality).
In terms of good news, we must also not forget the turning negotiated by the President of the European Central Bank (ECB), Mario Draghi, when he pledged to do “whatever it takes” to save the euro. We can go on about the question what would have happened if a government had decided to test the ECB’s resolution by waiving adjustment efforts. Even if the commitment by the ECB may have been a gamble, what matters now is that this operation was successful.
Financial markets did not remain insensitive to policy measures and good news. At first, they stopped speculating on the collapse of the euro zone, and then gradually, they realized that the euro area would get out of the crisis without breaking. This process has created a virtuous circle whereby the newfound confidence of investors has resulted in lower interest rate differentials with Germany, which has improved the financial outlook of the most vulnerable countries and thereby validated investor expectations. These encouraging developments do not mean that all the problems are resolved. They only indicate that the markets now believe that the risk of collapse of the euro has virtually disappeared and it is therefore rational to strengthen their lending activity and investment in the whole euro area.
Should we conclude that the euro is saved forever?
Not necessarily because the euro area is not an optimal currency area, nor a political and fiscal union. The euro remains a more fragile currency than the US dollar. The euro’s future depends on the will of the states to honor their commitments, adapt the institutional framework to new circumstances and take measures when things go sour. The euro crisis showed that this willingness is strong. This will have to stay like that when crises occur again.
Apart from this fundamental flaw in the architecture of the monetary union, what should we think of the problems the euro area is still currently facing, namely the threat of deflation, the weight of public debt and weak economic growth?
Fears of a deflationary spiral in the euro area are exaggerated. While the current rate of inflation (0.7% in April) is too low in relation to the objective of the ECB to keep the inflation rate at below but close to 2% over the medium term. If inflation remains at current levels, the reputation of the ECB would be damaged. The ECB therefore has no other choice but to act, and it has the means to do so.
Public debt is very high in many countries, but it is not a reason to consider debt cancellation measures. The functioning of the financial system is based on the principle that sovereigns honor the repayment of their debts. When a country is questioning this principle, it is sanctioned by the international community and it loses access to international bond markets. This is why a unilateral default payment can only be considered in exceptional circumstances. This solution does not make sense within the euro area. This is even more true that long-term interest rates are back to historically low levels. Regarding the implicit debt associated with the expected increase in pension expenditure, part of the solution should come from a controlled rise in budget deficits and public debt ratios. It is however not possible to consider this solution today because it would reduce the willingness of some countries to take structural measures to prepare for the demographic shock. However, this will need to be discussed in due course.
Finally, with regard to the current weak economic growth, it is the direct result of the austerity measures that have been revived too strongly in 2012. The damage has been done. It is now important to look to the future. In principle, budgetary policies should have a much less negative impact this year than in 2012-2013. The actions of the ECB against deflationary tendencies should also support growth. It is not possible, however, to assert that this rebalancing of macroeconomic policies will be enough to accelerate growth and improve the quality of life of the populations most affected by the crisis. The crisis has indeed left deep scars, especially in terms of unemployment, banks’ solvency and private debt in some countries. Moreover, the expected rise in U.S. interest rates should cause a rebalancing of capital flows and therefore a higher cost of credit for vulnerable economies and countries that are coming out of the crisis.
Under these conditions, European leaders should not be complacent. To minimize the risk that the economic recovery remains weak or weakens again, they should adopt an ambitious investment plan to strengthen infrastructures in the transport, telecommunications and energy sectors, which are suffering from a serious lack of funding. To avoid that the rules of the Stability Pact and Growth excessively constrain the ambition of such an initiative, the new investment should not be taken into account in the calculations in the framework of the excessive deficit procedure.
The aim of such a plan should be to fuel aggregate demand, strengthen the confidence of businesses and households and thus stimulate capital investment and private consumption. This initiative would also strengthen the growth potential of the euro area economy and thus respond to the legitimate concerns raised by the expected fall in long-term growth rates at unchanged policy.
In conclusion, the euro area is recovering at a faster pace than expected. Financial markets have welcomed this, which is good news. It is now important that companies and households take the lead by investing and consuming more. This is a necessary condition for consolidating the ongoing economic recovery and to ensure that pro-euro politicians continue to benefit from the support of a large part of the population.